Venture capital industry under the gun

Commentary: Data show a grim landscape; shakeup in the cards

By

ScottAustin

NEW YORK (MarketWatch) -- Well, there you have it. A "crisis" has hit the venture capital industry.

At least that's according to the National Venture Capital Association, the industry's trade group, which last week sounded the horn with a press release pronouncing a "Capital Market Crisis" for start-up companies. The NVCA was particularly irked that there were no initial public offerings of a venture-backed company in the second quarter, and none since March 19. We haven't seen a drought like this since early 2003 when there was a near five-month lull. See full press release.

Some poignant words from the NVCA's president, Mark Heesen: "We need to put regulators, legislators, presidential candidates, and the private sector on notice that this situation represents a serious problem that will have long reaching economic implications if not addressed. We view this quarter as the 'the canary in the coal mine'."

The NVCA's declaration adequately stirred the blogosphere, but my guess is that most venture capitalists shrugged their shoulders.

IPOs were a big part of a venture firm's exit strategy in the 1980s and 1990s, but in the past several years probably 90% or more of a firm's exits have come from merger and acquisition deals. Sure, the investment returns in a highly successful IPO can carry an entire venture fund, and a robust IPO market gives start-ups more leverage when negotiating an acquisition price with a potential buyer, but it now takes, on average, more than eight years to take a company public after its first investment. These days, VCs focus more on M&A deals.

What's more disconcerting is the M&A data released last week from research firm VentureSource. The number of venture-backed companies acquired in the past two quarters dropped drastically from a year ago, as did their total value. While that's a relatively short period to hit the panic button, it perhaps highlights the caution in the tech market right now. In fact, the second quarter saw just 56 such acquisitions, by far the lowest quarterly tally since at least 2000.

Also noteworthy: Cisco Systems Inc.
CSCO, +0.57%
which has acquired more venture-backed start-ups since 2000 than any other company -- by my count, 44 -- hasn't made such a deal yet this year. In fact, its last deal with VCs came in November when it agreed to acquire Securent Inc., a provider of policy management software.

Several other tech giants that were heavy acquirers last year, such as EMC Corp.
EMC, -1.87%
Google Inc.
GOOG, +0.48%
and Yahoo Inc.
YHOO
have made just one such acquisition apiece, while two others, Hewlett-Packard Inc.
HPQ, -0.23%
and Oracle Corp.
ORCL, +0.14%
have yet to buy a venture-backed company in 2008. (Cash-rich Microsoft Corp.
MSFT, -0.71%
heads this year's list with five acquisitions, showing it's not simply tied up with Yahoo.)

Prices already appear to be falling fast -- the median post-money valuation of companies acquired in the first half was $63 million, down from $93 million in 2007, VentureSource data show. But this year's number is still well above the median valuations from 2001 to 2006, and I'm betting VCs are trying desperately to keep prices from falling too low. After all, many longstanding portfolio companies waiting to exit are bloated with funding -- so far this year, the companies that have gone public or been acquired had raised a median of $22.2 million from VCs, the highest point this decade.

Perhaps we'll start seeing more deals like the acquisition of Web video company Kasenna Inc. Last week Kasenna agreed to be acquired by publicly traded Espial Group Inc. for about $6.5 million in stock. That's less than one-tenth the $70 million that Kasenna's 14 venture backers pumped into the company since 2000. But it pushes Kasenna into the public's hands and gives venture backers hope of a bigger payoff down the road. As Ted Mocarski, managing director at Kasenna investor Key Venture Partners, said about the deal: "The thought process was to really combine two companies and give yourself more leverage through those tough periods."

Likewise, drug maker OncoGenex Technologies Inc., which shelved its IPO filing last year, took a second chance at going public by merging with struggling Sonus Pharmaceuticals Inc.
SNUS
in May. The deal gave eight-year-old OncoGenex shareholders a 50% stake valued at only $12.2 million at the time, plus more if milestones are met. Going public through this route might give OncoGenex a better shot at raising the capital it needs to advance earlier-stage drug candidates.

Bottom line: The venture capital industry is due for a major shakeup over the coming years. As chronicled several times in this space, too much money has flowed into the venture capital industry from limited partners - pension funds, university endowments and other large institutional investors - creating too many companies with nowhere to go. VentureSource did a study last year showing that more than 1,400 companies funded during the hectic years of 1999 and 2000 still existed in venture firm's portfolios. A majority of these companies -- which received a total of about $50 billion in venture capital and employ more than 150,000 thousand people -- will have to shut down or sell on the cheap. Venture capitalists can't hold onto them forever. Read related column.

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